stern stewart roundtable on eva in europe

JOURNAL OF APPLIED CORPORATE FINANCE9898

BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE

STERN STEWART ROUNDTABLE ON

EVA IN EUROPEJune 26, 1998 Lisbon, Portugal

JOEL STERN: Good morning, andwelcome to this discussion of the EVAfinancial management system and itspotential for Europe. It’s always apleasure to be in Lisbon—especiallywhen the temperature in New Yorkhits three digits—and I welcome theopportunity to be with you.

Economic value added, contrary towhat you may have heard, is not justa U.S. phenomenon. With the help ofStern Stewart, companies have beenimplementing EVA in South Africa forover a decade. We have also beenworking in recent years with compa-nies in Germany, France, Brazil,Mexico, Sweden, Australia, NewZealand, and Singapore—not to men-tion firms in Canada and the U.K. Weare also advising companies in a broadrange of industries—everything fromconsumer products and industrialcompanies, high-tech and pharma-ceutical companies, to regulated com-panies such as banks, insurance com-panies, and public utilities.

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Moreover, our list of clients hasrecently expanded to include anumber of not-for-profit and gov-ernment-owned organizations. Andthis means that our focus at SternStewart is not just on increasingshareholder returns and shareholderwealth. Our aim is to help increasethe total value of all kinds of orga-nizations by putting in place a per-formance measurement and incen-tive system that encourages sus-tainable improvements in produc-tivity. The increases in total valueresulting from such improvementscan then be shared by all of anorganization’s constituencies—byemployees, customers, suppliers,and local communities as well asby shareholders.

My favorite case illustrating thepotential for such improvements isthe United States Postal Service,which four years ago adopted EVAwith our help. After figuring outways to assign capital and measureincome for its ten different geo-graphic areas and 85 so-called “per-formance clusters,” the Postal Ser-vice put 700 top executives on anEVA bonus plan in fiscal 1996, addedabout 62,000 managers and 17,000supervisors in 1997, and added an-other 35,000 employees in 1998. Asa result of EVA, many U.S. postoffice employees now have whatamounts to a “new deal” with theAmerican public—it’s a deal thatsays they will receive bonuses forimprovements in productivity, butwith a significant portion of thebonuses deferred and held at risk toensure that such improvements arenot temporary.

And the Postal Service’s perfor-mance since implementing this “newdeal” has been nothing short ofremarkable. After several years ofoperating in the red, it reportedprofits of $1.8 billion in 1995—thehighest ever, though that was pri-

marily the result of a postal rateincrease that year. The real proof ofsuccess came in 1996, when thePostal Service earned $1.6 billion,and followed that with $1.3 billionin 1997—both years in which in-creased levels of mandated capitalexpenditures obscured what wouldhave been considerably higher lev-els of profitability. But what is espe-cially noteworthy here is that this wasthe first time the Service ever achievedthree consecutive years in the black.And such profits, I hasten to add,have not come at the expense ofquality, but have been accompaniedby dramatic and well-documentedimprovements in service.

The purpose of this roundtable,then, is to consider the potential forEVA to improve productivity andincrease the value of European com-panies. In so doing, we will viewEVA in relation to more conven-tional measures of corporate per-formance like EPS and ROE, exam-ining its advantages as well as anypotential shortcomings. We will dis-cuss EVA not only as a measure ofoperating performance, but also asthe basis for the entire range ofcorporate financial managementfunctions, from capital budgetingand the setting of corporate goals toshareholder communication and, myspecial interest, management in-centive compensation.

To discuss these matters with us,we have assembled a first-rate panelthat includes three academics repre-senting distinguished European busi-ness schools and two members of theEuropean business community—onea corporate executive and the otheran investment banker. I will nowintroduce them in the order in whichthey will be speaking.JULIAN FRANKS is the Corporationof London Professor of Finance atthe London Business School. Julianhas done a great deal of highly re-

garded work in a number of corpo-rate finance fields, including the Eu-ropean corporate control marketsand European corporate governance.DAVID YOUNG is Professor of Ac-counting at INSEAD, France’s well-known business school. In additionto teaching MBA students, Davidruns seminars for corporate execu-tives in companies throughout Eu-rope and Asia. He also serves as aconsultant on value-based manage-ment for several European and Asiancompanies.ANTONIO VERTUCCI is the Con-troller and Chief Information Of-ficer of Ausimont, the leading chemi-cal company of Montedison. Hejoined the Montedison Group in1993, after having worked for Nestléas a product manager. Antonio holdsa BBA from Italy’s prestigiousBocconi University, where he hasalso received the CPA certificate.Before completing his degree atBocconi, Antonio specialized ininternational business and corpo-rate strategy at the University ofMichigan’s Graduate BusinessSchool.MIGUEL AZEVEDO is Chief Oper-ating Officer of Central Banco deInvestimento, a Portuguese invest-ment bank that specializes in bothlisted and unlisted equities. Miguel’sresponsibilities include corporatefinance, development capital, eq-uity capital markets, and equityderivatives.MASSIMO SPISNI is a Professor ofFinance at the University of Bolo-gna, and at SDA Bocconi Univer-sity. Massimo is now at work on themonumental task of translating all845 pages of a book by my col-league Bennett Stewart called TheQuest for Value. In the interest offull disclosure, I should tell you thatneither Bennett nor I have ever metanyone who claims to have read all845 pages.


A Brief Introduction to EVA

STERN: Let me start by concedingthat the basic concept behind EVAhas been a part of the economist’stool kit for more than 200 years. In itsmost fundamental form, it is thesimple notion of “residual income.”That is, for investors to earn an ad-equate rate of return on their invest-ment, a company must earn a returnon its total capital employed that ishigh enough to compensate inves-tors for the risk of the business. Bytotal capital employed, I mean thesum of the firm’s debt and equity.Residual income is zero if a firm’soperating return is just equal to therequired return on capital.

Now, the accountant’s measure ofprofit, known as net income or bot-tom-line earnings, also subtracts arequired return on the P & L—butonly for the senior securities; it sub-tracts only the interest cost of debtand the dividends paid on preferredstock. There is no charge for com-mon equity, and so common share-holder funds are allowed to “freeride.” Accounting theorists justify thisexclusion of equity costs from the P& L by suggesting that all net profit isattributable to shareholders and thatthe shareholders must determine forthemselves what is a necessary orrequired return.

Of course, the critical issue is thekind of behavior that is likely to resultfrom the use of EVA vs. bottom-lineearnings, especially if the performancemeasure is used to evaluate newinvestment opportunities, includingmergers and acquisitions, or to moti-vate management through incentivecompensation. If the charge for capi-tal is too small, managers are likely tooverpay for acquisitions and take onother investments that end up reduc-ing the value of the firm. Charge toolittle for capital and there is no incen-tive to economize on its use.

So one part of the EVA story iscalculating the required return in away that includes all sources of capi-tal. At least as important, however,is getting the calculation of the op-erating return right. On this score,the accounting framework is a disas-ter. We at Stern Stewart have identi-fied some 120 potential distortionsof economic reality in generally ac-cepted accounting principles—orGAAP for short. Not all these prob-lems are material, of course. Butunless managers correct the mostimportant of these distortions, theEVA measurement will be much lesseffective in improving managers’decision-making.

In my view, perhaps the most im-portant reason for EVA’s popularity isits success in converting accountinginformation into a picture of eco-nomic reality that can be readily ap-preciated by non-financial managers.In almost every EVA training programwe have conducted for our clients,the participants—and these are typi-cally operating managers who havedifficulty understanding audited fi-nancial statements—have come to usand said about EVA, “Now this reallymakes sense!”

Let me give you a few examplesof the accounting distortions thatcan really confuse operating man-agers. One is the habit of accoun-tants of fully expensing capital ex-penditures in the current year whenthey really belong on the balancesheet as long-lived assets. For ex-ample, GAAP calls for expensing theentire current year’s spending onR&D, thereby understating the firm’seconomic income. The EVA ap-proach, by contrast, capitalizes R&Dand writes it off over its expecteduseful economic life—say, five years.The EVA treatment of advertising andpromotion for firms like Coca-Colaand Johnson & Johnson does thesame, although advertising and pro-

motion have a much shorter expectedlife than most spending on R&D.

By making such adjustments, EVAreinforces managers’ intuitive sensethat these investments help firms buildlong-term sustainable value in theform of new products and trade-marks. The more general problemwith GAAP is that it takes the short-term view of the lender and assumesthat investments in intangibles likeR&D and brandname have no value ifa firm fails. In other words, GAAPfocuses on a firm’s liquidation value—but EVA attempts to capture a firm’svalue as a going concern.

Another potentially important ac-counting distortion is deferred taxes.Under EVA, taxes are recorded onlywhen paid. Because we want manag-ers to focus on cash, EVA adds theannual provision for deferred taxesback to operating income and treatsthe entire deferred tax account as partof shareholders’ equity. The reasonfor the latter adjustment is that thedeferred tax account represents cashcapital on which managers must earnan adequate return.

The conventional accounting foracquisitions also distorts economicreality. In contrast to GAAP, EVArecords the full price paid for acqui-sitions no matter how they are fi-nanced. In effect, this means pooling-of-interest is out and purchase ac-counting is in. Only if the full pricepaid is put—and kept—on the bal-ance sheet can we expect managers toput strict limits on how much they willpay for acquisitions. Because theyleave out the goodwill premium,poolings are more likely to encourageoverpayments.

We also have a problem with bothaccelerated and straight-line depre-ciation of long-lived assets like plantand equipment. By having larger-than-average depreciation charges inearly years, GAAP significantly un-derstates near-term profit and assets.


To reflect the actual pattern of de-cline in plant and equipment’s eco-nomic value, EVA uses somethingcalled “sinking fund depreciation.”Like a home mortgage in which prin-cipal repayments are small in theearly years, the depreciation chargesfor plant and equipment are rela-tively small in early years, but risesharply in later years as the plant andequipment begins to wear out. Forcapital-intensive firms, this adjustmentcan be material.

So, this is just a sampling of thekinds of problems that can arise fromGAAP accounting. In many if notmost cases, GAAP distortions of eco-nomic reality can lead to a seriousmisallocation of resources within thefirm. What would you do, for ex-ample, if up to 50 percent of yourtotal compensation was tied to growthin annual earnings and you detecteda deteriorating profit margin? Wouldyou be tempted to cut back onR&D or advertising to ensure yourown bonus?

In sum, EVA is not just a perfor-mance measure. More important, it isthe basis for incentives that drivebehavior. I understand that some com-panies—not our clients, of course—are using EVA for strategic planningand evaluation purposes but not forincentive pay. That is a big mistake. Ifyou measure performance on onebasis, but pay bonuses according toanother, most people will pay lipservice to your stated goal and man-age the variables that affect theirbonuses. The real payoff from an EVAfinancial management system comesfrom the direct linking of a betterperformance measure with incentivecompensation.

Let me also point out that when wedevise an incentive scheme, bonusesare generally based not on the abso-lute level of EVA produced by amanager or an operation, but ratheron the year-to-year improvement in

EVA. The financial management goalis continuous improvement in EVA.One advantage of tying bonuses toimprovements in EVA is that suchbonuses come at no cost to the share-holders. The management bonusesearned under an EVA system areeffectively paid for out of the muchlarger increases in shareholder valuethat accompany such EVA improve-ments. In other words, employeeswith EVA-based incentives are par-ticipants—partners, if you will—inthe sustainable increases in produc-tivity that they help bring about.

Another important feature of ourincentive compensation system is whatwe call the “bonus bank.” We payonly part of the declared bonus—say,one third—upon declaration; the re-maining two thirds is held at risk andsubject to loss if you don’t sustain theimprovement. In other words, in or-der to receive the full award, you mustincrease your EVA and at least main-tain that new level of EVA for the nextseveral years thereafter.

Besides strengthening manage-ment’s incentives in a way that doesnot dilute the shareholder interest, yet

Joel Stern

The critical issue is the kind of

behavior that is likely to result

from the use of EVA vs. bottom-line

earnings as a performance

measure. If the charge for capital is

too small, managers are likely to

overpay for acquisitions and take

on other investments that end up

reducing the value of the firm.

Charge too little for capital and

there is no incentive to economize

on its use.


another important potential benefit ofEVA is that it can help companiescommunicate more effectively withthe investment community. We havefound in the U.S. and in the U.K.—andmore recently in Germany as well—that institutional investors want tobuy shares in companies that an-nounce they are adopting EVA. Why?Because an EVA system acts as apoliceman to make sure that corpo-rate resources are not wasted.

Why Now?

One question we are often asked isthis: If EVA is such an old idea, whyhas it failed to catch on until now? Theanswer can be found by tracing thecourse of a revolution in financialeconomics that started about 40 yearsago. The story begins with a series ofpapers published by Nobel laureatesMerton Miller and Franco Modiglianiin the late 1950s and early ’60s. For thefirst time, the basic theory ofmicroeconomics was applied to cor-porate finance—and the result was anew economic model of the firm thatwas clearly different from the ac-counting framework taught in con-ventional corporate finance coursesat that time. Miller and Modiglianishowed that the key drivers of valueare economic income and a requiredrate of return that is directly propor-tional only to an asset’s business risk—and that the required return is notaffected, apart from possible tax con-siderations, by how a firm is financedor whether it pays high or low divi-dends. In its simplest terms, the M &M framework showed us why thediscounted cash flow approach tovaluation is most consistent with howmarkets work in the real world—andthus why managers should use DCF ifthey are concerned with the impact oftheir decisions on shareholder value.

And, over the next two or threedecades, the DCF concept and the

associated measure of net presentvalue were widely accepted andadopted by U.S. corporations, at leastfor capital budgeting purposes. But,unfortunately, when measuring per-formance and setting incentive com-pensation targets, the senior man-agements of most corporations con-tinued to cling to accounting mea-sures—even as our premier businessschools graduated over 100,000 MBAsbetween 1958 and 1991. So, in thisrespect, the theory being taught inour business schools was not beingtranslated into practice. Somethingwas wrong, and it was not just theperformance measure. So-called con-glomerates became all the rage; di-versification was in, single-industryfirms were out. Highly successfulfirms, including even Coca-Cola, ex-perimented with unrelated activitieswith dismal results. In the majorityof conglomerate acquisitions, thebuyers’ shareholders experiencedsignificant losses—if not at the timeof the transaction, then in the yearsthat followed.

As finance theory suggested, theconglomeration of firms representedredundant diversification—diversifi-cation that could be easily accom-plished by investors simply by diver-sifying their own portfolios. Further-more, whereas investors could ac-quire interests in companies at exist-ing market prices, conglomerates wereforced to pay premiums to acquirecontrol of their “portfolio compa-nies.” Such premiums, whichamounted to a huge waste of investorcapital, led to a systematic destructionof shareholder value. And within areasonably short time, the lead steerssent this message in exclamation pointsto those managements by drivingdown their share prices.

Although this is not often pointedout, conventional performance mea-surement and incentive compensa-tion schemes played a major role in

the U.S. conglomeration movement.Instead of using DCF and net presentvalue to evaluate prospective acquisi-tions, senior management and boardsof directors retained the accountingframework and focused on earningsper share. We all remember thosedays when firms with high price-to-earnings ratios used their stock topurchase firms with lower P/Es be-cause the buyer’s EPS would auto-matically increase. And the reversetransaction was shunned because itlowered earnings per share. This wasthe height of accounting-drivenfolly, since the combined firms wereexactly the same no matter who didthe acquiring.

So, even as finance professors wereteaching their students that discountedcash flow and NPV were the primarydeterminants of value, EPS concernscontinued to rule the day inside cor-porations. Why did companies rejectNPV? The problem with NPV is that itis a multi-period, “stock” measure ofvalue that does not lend itself to asingle-period performance evaluation.EVA solved this problem by in effectdecomposing NPV into annual—oreven monthly—“installments” of valueadded. Over a sufficiently long periodof time, EVA and NPV give identicalanswers in evaluating performance.But because EVA is a “flow” ratherthan a “stock” measure, it can be usedas the basis for a period-by-periodperformance evaluation and incen-tive system.

The Rise of Agency Theory

So, to backtrack a bit, the Miller-Modigliani papers were largely re-sponsible for validating the economicmodel of the firm and NPV as avaluation tool to guide decision-mak-ing. The second major step in thepost-1958 revolution in finance theorywas the publication of a paper on“agency costs” in 1976 by Professors


William Meckling and Michael Jensen,both then at the University of Roches-ter. The main thrust of their argumentwas that because managers could beexpected to subordinate investor in-terests to their own agenda, lendersand shareholders would have to incurmonitoring costs to hold manage-ment accountable. In the absence ofsome kind of policing action by out-side investors to control management,firms would squander large amountsof potential shareholder value. Andthe situation at the time was madeworse by the leftist political economicclimate of the 1970s that encouragedmembers of boards of directors tofollow an independent line—inde-pendent, that is, of shareholder con-cerns and in favor of other constituen-cies, including suppliers, labor, localcommunities, and the environment.At least as harmful, directors encour-aged management to increase marketshare and to achieve growth for itsown sake, even if shareholder valuewas sacrificed.

Then, as if to confirm the thinkingof Jensen and Meckling, there camethe leverage revolution of the 1980s—the expansion of the junk bond mar-ket, the wave of hostile takeovers,and the remarkable successes of theLBO movement. And, in 1986, MichaelJensen published an article in theAmerican Economic Review called“The Agency Costs of Free Cash Flow:Corporate Finance and Takeovers.”This article, in my opinion, offers thesingle most powerful explanation ofthe leveraged restructuring of the1980s. The theory, in brief, said thathighly leveraged acquisitions, stockbuybacks, and management buyoutsof public companies were addingvalue by squeezing excess capitalout of organizations with few profit-able growth opportunities. Jensen ob-served that managers in mature in-dustries have a natural tendency tohoard capital, to reinvest corporate

cash flow in declining core busi-nesses—or, perhaps even worse, indiversifying acquisitions—instead ofpaying it out to shareholders in theform of dividends or stock repur-chases. And conglomerates are thusboth a symptom of this “free cashflow” problem as well as a majorcause. In the ’70s and early ’80s,companies with lots of cash, or un-used borrowing capacity, purchasedcompanies in unrelated businesseswhen they ran out of good opportu-nities in their core business. And,once having become conglomerates,managers then used the excess cashflow of profitable businesses’ cashflow to cross-subsidize low-returnbusinesses, thus dragging down thevalue of the whole.

In Jensen’s view, the massive sub-stitution of debt for equity in the ’80sprovided a solution to this corporatefree cash flow problem by convertingdiscretionary dividend payments intoconsiderably more demanding pay-ments of interest and principal. Tak-ing a company financed with 20%debt and leveraging it 9 to 1 has theeffect of making its cost of capital bothexplicit and contractually binding. Inso doing, LBOs and leveraged take-overs—and the defensive leveragedrecaps in response to hostile offers—forced U.S. conglomerates to sell offbusinesses that didn’t fit. It was eitherdismantle, or be dismantled.

And Jensen was especially im-pressed by the successes of the U.S.LBO movement. In a 1989 HarvardBusiness Review article called “TheEclipse of the Public Corporation,”Jensen described LBO organizationslike KKR as a “new organizationalform” that was destined to replacepublicly traded conglomerates. It wasthe combination of heavy debt fi-nancing and concentrated stock own-ership, including significant owner-ship by managers, that caused the bigimprovements in productivity.

Now, the reason I see Jensen’spapers as important precursors of theEVA movement is that EVA can beused to accomplish the same thing asleverage and LBOs, but without thecosts and risk associated with highleverage. EVA also makes the cost ofcapital explicit, and the incentive com-pensation program represents a con-tract of sorts between managers andshareholders—a contract that says tomanagers, “You get rewarded if andonly if you earn the cost of capital onnew investments, and increase theEVA of existing capital.” And thepossibility this raises is this: If themanagements of most U.S. compa-nies had been on EVA programs in thelate ’70s, perhaps much of the effi-ciency gains and value increases ofthe ’80s could have been accom-plished without the high leverage.

Of course, Jensen’s prescription ofhigh leverage was meant to applyonly to firms in what might be de-scribed as “mature” industries withfew profitable investment opportuni-ties—industries like oil and gas, forestproducts, and cement, where compa-nies were throwing off lots of cashflow that could be used to service thedebt. But I am not convinced that debtfinancing is the best solution for eventhese companies. As I just said, anEVA-based incentive system is alsodesigned to deal with this corporate“free cash flow” problem. And be-cause our system can be taken welldown into the corporate structure—that is, into the individual businessunits and below—I would argue thatEVA might be more cost-effective thandebt financing in discouraging thecorporate waste of capital. That is,assuming debt creates a valuable dis-cipline for management in certaincases, why wouldn’t the “localized”incentives provided by an EVA planbe expected to do an even better job?After all, too much debt can discour-age all corporate investment, good as


well as bad. An EVA system encour-ages managers to fight for just thoseprojects that promise to earn at leasttheir cost of capital.

You see, I’ve always held the viewthat there is no such thing as matureor dying industries, only dormantindustries waiting to be rejuvenated.The evidence from hundreds of suc-cessful implementations suggests tome that most companies possess enor-mous amounts of “hidden value,”untapped sources of efficiency thatare discovered when EVA incentivesare carried down through the organi-zation and all employees becomepartners in adding value. And that’swhy I believe this role for debt islargely unnecessary—or a second-best solution—in companies with awell-structured performance evalua-tion and incentive system.

Take the case of the automotiveparts industry, where we have hadconsiderable experience in recentyears. Soon after going onto EVAprograms, companies like SPX andFederal-Mogul quickly exceeded allexpectations for profits—and evenfound new growth opportunities inthe process. And the same has hap-pened to Herman Miller in the officefurniture industry. Although each ofthese companies could have beencandidates for Jensen’s medicine ofheavy debt—and in fact SPX did usethis prescription, in the form of adutch auction self-tender, to comple-ment its EVA program—I would ar-gue that the heavy debt financing isunnecessary. Why? Because, by tak-ing EVA incentives down to the shopfloor, each of these firms convertedtheir average workers into what I liketo call “value-change agents.” In thefirst 28 months after going on theirEVA plan, SPX’s share price increasedmore than fivefold from $15 to $78,and Herman Miller’s price quadrupledin less than two years. And today,when firms simply announce their

intention to implement our brand ofEVA, we have found that their shareprice gains as much as 30% in just oneweek! The most recent example oc-curred in February of this past year,when Omnicare’s shares increasedfrom $28 to $39 after announcing itwas adopting EVA.

In closing, let me just say to you thatthe brand of EVA that we provide ourclients is different from other versionsof economic profit. As I said earlier,it’s not simply a new performancemeasure, but rather a behavioralchange system—one that attempts tocreate a value-conscious corporateculture by making all managers andemployees active and committed par-ticipants in the process of creatingtotal wealth. To a far greater extentthan, for example, the ESOP move-ment, EVA has the potential to createa truly productive kind of employeecapitalism. How do we know? Be-cause even U.S. government and othernon-profit organizations that havegone on EVA—and also U.S. publicutilities, where signs of a culture ofvalue maximization were also almostcompletely non-existent—are becom-ing the envy of private sector firms. AsI mentioned earlier, the U.S. PostalService is a particularly noteworthyexample of a once chronically ineffi-cient and wasteful organization thathas achieved remarkable improve-ment. And I suspect that EVA can dothe same for many European organi-zations—in the public sector as wellas the private.

So, with that introduction to EVA,let’s now hear what our panelists haveto say. And why don’t we begin withJulian Franks, who is Professor ofFinance at the London BusinessSchool. Julian, could you share withus your experience in teaching EVA toyour students and to corporate execu-tives, and tell us a bit about what youfeel are the drawbacks as well as thebenefits of such a system?

The Role of EVA in Bridging theGap between Financial Theoryand Practice

JULIAN FRANKS: Well, first of all, letme make it clear that I have nopersonal stake in EVA. In fact, I didn’tteach EVA in the classroom untilabout a year ago. I taught EVA in theform of a case called “Knothead,”which appears in the latest edition ofthe Brealey and Myers textbook. Andone of the things that’s puzzled mesince then is that whereas the aca-demic corporate finance professionhas done an extraordinarily effectivejob of communicating concepts suchas discounted cash flow, capital assetpricing models, and option pricingmodels, until the recent emergence ofEVA we’ve demonstrably failed toprovide our students with an effectivemethod for evaluating periodic cor-porate performance. We all continueto run across companies that use thecapital asset pricing model for capitalbudgeting purposes and show othersigns of financial sophistication. But,as Joel said, when it comes to per-formance measurement and incen-tive compensation, many of theprinciples of economic valuationare simply ignored.

Instead of encouraging managersto produce high cash flow returns,most corporate evaluation and in-centive systems reward managers forproducing growth in earnings or earn-ings per share. And other popularmeasures such as ROE and ROI alsosuffer from many of the same ac-counting distortions that we oftenwarn our students about. The mys-tery in all this is that, although manyof the companies I’m aware of havebecome financially sophisticated inmost respects, they almost neverchange their internal measurementsystems. And this leads me to con-clude that, until Stern Stewart camealong with EVA, we were somehow


failing to communicate these con-cepts to our students—and to thegeneral business community.

The accomplishment of EVA, then,has been to gain broad acceptance byfinancial practitioners for concepts ofeconomic value that have long beenembedded in the theory of finance. AsI’ve said to Joel on several occasions,I don’t think there’s anything remark-ably new about the concept of EVA.Yet, it somehow has managed tooperationalize those existing con-cepts—and to do it in a way that mostpeople can understand.

I am interested to know whether it’sthe operationalization of EVA that wasimportant, or whether managementwas just ready for the change. That is,if we had gone on teaching Knotheadto our students, would we have finallymade an impression? I suspect theanswer is that we wouldn’t have. So,in that sense, I think EVA did some-thing that we demonstrably failed todo—which was to communicate eco-nomic measures of performance ap-praisal. We failed to provide the cor-porate world with a measure of eco-nomic profit that could serve as thebasis for periodic performance evalu-ation and incentive compensation.

Now having said some nice thingsabout EVA, let me mention somereservations or qualifications that haveoccurred to me while teaching it to mystudents (as I said, I have no stake inEVA, I’ve received no payoff whatso-ever, as should soon become appar-ent). And I have put these reserva-tions under three headings.

First of all, Joel makes much of thefact that EVA compensates managersonly when they bring home the ba-con—that is, managers only get theirreward when the cash flows come in.Now, I can understand the reasoningfor that, at least in most circumstances.The implicit assumption is that man-agers have both discretion over andthe best information about the even-

tual outcome of their projects, andthat they accordingly should receivetheir compensation only when ex-pectations are realized. After all, if thebonuses are paid and the expectedcash flows fail to materialize, share-holder losses will be compounded byundeserved bonus payments to man-agers—a situation that is likely tomake shareholders very unhappy.

But there are other cases wheresuch a compensation scheme may beunduly conservative and so fail toprovide managers with rewards thatare commensurate with their value

added. Consider a case where, onceyou make a major investment, youdon’t have much discretion—you havelittle opportunity to affect the out-come with a further series of deci-sions. Let me give you a favoriteexample of mine: a financial lease.Once you invest in a financial lease,you can—at any given moment intime—lock in the entire profit overthe life of the lease. You can literallyinvest in a financial lease, take the netpresent value, and go off to Bermuda.In that case, why not compensate theperson for the entire net present value?

JulianFranks

What I would like to see is an

EVA measure that is adjusted for

economy- or industry-wide

conditions. This way, if the broad

market or the entire industry has

an extraordinarily good or bad

year, then the cost of capital—the

benchmark—would be adjusted up

or down to reflect such external

factors. By doing this, EVA would

be more like the “abnormal return”

that we academics use in our

corporate “event” studies—and

that many financial institutions

now use in evaluating the

performance of their money

managers.


Now, obviously, the world is madeup of a spectrum of investment op-portunities ranging from those whereyou have huge amounts of manage-rial discretion to those with very littlediscretion. And you need to be verycareful in determining how muchopportunity managers really have toaffect project outcomes after the ini-tial decision. But, in those cases wherethe value of a decision can be clearlyestablished—and locked in—then aneffective evaluation system shouldcompensate the manager for the en-tire gain. So, I would like to see a littlemore flexibility in EVA to take ac-count of these stock as opposed to“flow” gains.

My second criticism of EVA is amore fundamental one. It has to dowith Joel’s benchmark, which is thecost of capital. And, to illustrate myconcern about this benchmark, let metell you a story. I’m a director of anindexed fund, and I’m also a trustee ofa charity, both of which have largeamounts of funds under management.We have two investment managers: apassive one and an active one. Thepassive one earned 27% over the firstsix months of the year. The active oneearned 24% over the same period.And let’s assume for simplicity that theweighted average cost of capital is12%. Now, the question is: How shouldwe evaluate the performance of theactive manager in this case?

According to Joel, 24% is greatbecause it beats the cost of capital by1200 basis points. But the importantconsideration, in my view, is that this24% is 300 basis points below themarket-wide return. We’re not firingthe active managers yet. But if theycontinue to underperform the mar-ket, we’re not going to continue toemploy them.

Now, what’s this story got to dowith EVA? It seems to me that, inestablishing the benchmark for cor-porate operating performance, com-

panies should be using some equiva-lent of the market index that is usedto evaluate the investment perfor-mance of money managers. The EVAsystem would do a much better job ofidentifying management’s contribu-tion to value by using as its bench-mark not the cost of capital, but someindex of corporate profitability,whether measured on an industry- oreconomy-wide basis. That is, a man-ager may beat the cost of capital, butif GDP has gone up and demand hasgone up in that industry, the increasein EVA may have very little to do withthat manager’s performance.

What I would like to see, then, is anEVA measure that is adjusted foreconomy- or industry-wide condi-tions. This way, if the broad market orthe entire industry has an extraordi-narily good or bad year, then the costof capital—the benchmark—wouldbe adjusted up or down to reflect suchexternal factors. By doing this, EVAwould be more like the “abnormalreturn” that we academics use in ourcorporate “event” studies—and thatmany financial institutions now use inevaluating the performance of theirmoney managers.

So that is my second criticism, andnow here is my third and final one—and this is not really a criticism, moreof an observation. Joel said that themarket value of a company at anygiven time equals the net presentvalue of all the cash flows that areexpected to be generated by the firm’sinvestment opportunities. But themarket value of the firm containssomething else; it contains growthopportunities—that is, investmentopportunities that are not yet foresee-able, but that are likely to arise as aresult of the firm’s existing invest-ments. Pharmaceutical companiesinvest in research that is expected toproduce drugs, but the drugs are nothere yet; they are the basis of the hugeprofits of the future. Do we compen-

sate the managers for creating thisfuture growth value or not?

In the case of pharmaceutical com-panies, the answer is clearly yes;stock options, for example, are fairlyeffective in capturing such future ex-pected gains. But, in other caseswhere the link between current in-vestment and value is not quite soclear, I’m not sure how we shouldcompensate managers for makinglong-term investments. So I’d like tohear from Joel how he deals with thenet present value of investments witha very distant payoff.STERN: Julian, in fairness to the otherpanelists, I would prefer to hold offdiscussion of your second criticism—the benchmark problem—and justrespond briefly now to your first andthird points. Both of these arguments,it seems to me, are related to the issueyou began by raising: That is, shouldwe reward only current cash flowreturns? Or should we instead, incases where current cash flows do apoor job of representing future prof-itability, also use other indicators aswell as current cash flow or EVA?

As I mentioned earlier, we do at-tempt to build a longer-run horizoninto our EVA measure by doing thingslike capitalizing R&D expendituresand writing them off over, say, a five-year period. And, for other kinds oflong-lived investments, including ac-quisitions with large amounts of good-will, we also have a “strategic ac-counting” adjustment that keeps ma-jor investments off of the balancesheet and the associated capitalcharges off the P&L. Those adjust-ments are made according to aschedule that operating managersand headquarters can agree on—though, of course, the long-run NPVmust be positive for the adjustmentsto pass muster.

But these adjustments still do notsolve the problem of the financiallease you cited earlier. In that case, as


you correctly point out, the entireNPV is created in a single period, eventhough it may take years for the cashflows to be recorded on the P & L. Andlet me just mention that we have comeup with a solution to this kind ofproblem, at least in the case of extrac-tive industries. In a paper called “Howto Use EVA in the Oil and Gas Indus-try,” my associates John McCormackand Jawanth Vytheeswaran present amethod for incorporating into EVAthe year-to-year changes in the valueof an oil company’s reserves. And Ibelieve this is what you’re askingfor—namely, a “stock” as opposed toa single-period “flow” measure thatattempts to capture the entire netpresent value of an investment in theperiod in which the investment’s pay-off becomes clear.

As you suggest, Julian, managersought to be rewarded for at least someportion of such value added, espe-cially if the value is truly locked in andunaffected by future changes in mar-kets or managerial decisions. The keyquestion, of course, is whether and towhat extent this method can beadapted to other industries.

But, having said that, let me nowturn to David Young, who teachesaccounting and finance at INSEAD.David, what has been your experi-ence with EVA?

An Accountant’s Perspectiveon EVA

DAVID YOUNG: Let me start by echo-ing Julian Franks’ comment that oneimportant advantage of EVA is that,for some reason, it has a powerfulresonance with corporate managersthat alternative ways of teaching cor-porate finance do not. And I knowthis from doing lots of executive semi-nars at INSEAD for European manag-ers, and in the United States and Asiaas well. For some reason, the conceptof EVA, which is one that finance

professors have been teaching for thelast 30 years under the name “residualincome,” has a lot of meaning foroperating and marketing people, forpeople who are instinctively hostileto finance and conventional account-ing. And that’s one of the reasons whyI’m enthusiastic about the concept.

When you look at the basic ideasabout EVA—and Joel Stern himself isthe first to admit this—the ideas them-selves have been around for a verylong time. For example, in 1965, aWharton accounting professor namedDavid Solomons wrote a classic bookon residual income; it is a very goodlittle book, and I urge people to readit to this day. And there are otherpredecessors of EVA. For example,Alfred Sloan, in his autobiography MyYears At General Motors, talks in de-tail about an EVA-type compensationsystem that he implemented for hissenior managers at General Motors in1918. Some people trace the ideaback to Alfred Marshall in the 1890s,and some identify the source as AdamSmith 200 years ago.

The message behind the concept isvery simple: all capital has a cost. Inthe case of debt, the cost is reflectedin the interest payments; as Joel said,it’s both visible and contractually bind-ing. In the case of equity, it’s anopportunity cost—the rate of returninvestors expect to earn on invest-ments of comparable risk. The basicmessage of EVA to companies is that,to add value for your shareholders,you have to earn at least your cost ofcapital—and this is an idea that, asJoel said, is at the core of the moderntheory of corporate finance.

But if this idea has been around forso long, what has changed from thedays of Alfred Sloan that would causeEVA to become so prominent? What’sdifferent in the 1990s? Well, a fewimportant things have changed. Firstof all, as we all know, there is anunprecedented degree of pressure on

corporate managers to deliver returnsto shareholders. And the major rea-sons for this, as I see it, are thederegulation of capital markets, ad-vances in information technology, andthe growth of institutional invest-ment—all of which are creating mas-sive pools of investment capital withan unprecedented degree of mobility.Mobility means that investors candisinvest when they are dissatisfied.And when investors can disinvest,that in turn means that, in order tosurvive, companies not only have togain market share in product markets,they also have to convince capitalproviders that they can deliver value.This heightened pressure for perfor-mance exists not only in the U.S., butis spreading throughout Europe—and, although still in its infancy inAsia, we are starting see glimmers ofa shareholder value movement thereas well. And with this growing pres-sure for performance by investors hascome a demand by companies forbetter ways to measure their perfor-mance—that is, for measures that aremore consistent with the goal of cre-ating shareholder value and that thuscan be used as a basis for motivatingmanagers to achieve it.

So, that’s one important reasonwhy EVA has come into favor. Butthere are a few other reasons thathave to do with how EVA differsfrom David Solomons’ concept ofresidual income. For example, whencorporate managers would readSolomons’ book, they would ask in-stinctively, “Well, what do you meanby cost of equity?” Nobody had aclue as to what that meant. One ofthe advances of EVA over economicprofit or residual income is that itincorporates the concepts of the capi-tal asset pricing model. Whether youbelieve the CAPM is right or wrong isa different question—and that’s some-thing that financial economists de-bate all the time. But the rise and


refinements of the CAPM in the ’70sand ’80s have helped make possiblethe implementation of the residualincome measure called EVA. It hasprovided credible, defensible esti-mates for the cost of equity. And thisis a profoundly important advancethat has made it possible for peopleto use residual-income type mea-sures inside organizations. So that’sanother important difference betweenwhat’s going on now and what wenton, say, 30 or 40 years ago.

Another important distinction be-tween EVA and the residual incomeor economic profit measures that pre-ceded it is EVA’s emphasis on ac-counting adjustments. Now, althoughI do have some disagreements withthe way Stern Stewart goes about this,I think these adjustments are an im-portant part of the EVA story. Thereason I think these adjustments arepotentially valuable is that they allowthe measure to be driven deep intoorganizations. We want to bring per-formance measures down into thedivisions, and all the way down to thefactory level if possible, and then useit as part of incentive compensationsystems. This way managers through-out the organization can be evaluatedand compensated in a way that isconsistent with the over-arching goalof creating shareholder value.

So, the idea is that when we bringEVA down into the divisions, compa-nies no longer need to be constrainedby GAAP accounting. Since thesenumbers are intended primarily forinternal purposes—that is, perfor-mance evaluation and determiningmanagerial bonuses—the companycan make whatever adjustments itfeels are necessary to produce num-bers that are more accurate reflectionsof shareholder value creation. And,because this measure is also allegedlymore highly correlated with changesin shareholder value, companies canpay people based on this measure in

full knowledge that they are not cheat-ing the shareholders.

And this leads me to the importantfinal ingredient of the EVA system,and that’s incentive compensation.The basic idea of EVA-linked com-pensation is two-fold as I see it. Oneaspect is to reduce agency costs bygetting managers and employees tothink and act more like they’re own-ers of the company and not justemployees. The second is to makeany additional compensation that theywould receive from EVA-linked com-pensation effectively “self financing.”In other words, employees only getmore pay because they’re deliveringmore EVA, and the more EVA theydeliver, the more value they’re creat-ing for their shareholders. For allpractical purposes, it’s not really cost-ing the shareholders anything.

But the validity of this last argu-ment—the idea that EVA is self-fi-nancing—depends on the strength ofEVA’s linkage with shareholder value.And let me repeat that statement: aperformance measurement and in-centive system like EVA works if, andonly if, we’re confident that the per-formance metric is consistent withshareholder value. Before adoptingEVA we want to ensure that, when-ever managers increase EVA, they arealso increasing shareholder value. Andthis in turn implies that changes inEVA must be reasonably well corre-lated with changes in share price.

Now, at present, we don’t havemuch evidence to support that propo-sition. It’s true that a number of ar-ticles that have appeared in the Jour-nal of Applied Corporate Finance haveaddressed this issue. The problemwith this, of course, is that most of thearticles are written—and the journalitself is edited—by Stern Stewartpeople. Stern Stewart and other EVAadvocates try to convince us that EVAis more highly correlated with share-holder value than conventional ac-

counting measures because EVA cor-rects for biases and distortions that arejust an inherent part of generallyaccepted accounting principles.

So, that’s one issue where I wouldlike to see more clarification—and byindependent researchers. The oneacademically rigorous study on theissue was not favorable to EVA. Biddle,Bowen, and Wallace, in a recent ar-ticle in the Journal of Accounting andEconomics, show that conventionalaccounting earnings outperform EVAin explaining stock returns. No one,including Stern Stewart, has effec-tively refuted these findings.

My other concern about EVA hasto do with some of its proposedaccounting adjustments. While I agreewith the logic behind almost all ofthem, let me step back a moment andsay a word in defense of account-ing—because accounting is my field,and if I don’t stand up for accoun-tants, nobody will. In promoting EVA,Joel is playing on a common preju-dice that not just finance people have,but also corporate line managers. It’sa bias against accounting generally;more specifically, it’s a bias againstGAAP-produced numbers. As anyowner of a private business will tellyou, there can be pronounced differ-ences between accounting earningsand operating cash flow. Given achoice between higher earnings andhigher cash flow, most owners pre-fer cash, especially if you don’thave to explain your results to out-side shareholders.

When explaining this concept toour students, we like to use the ex-pression “cash is king.” But, as I tellthe students in my financial analysisclass at INSEAD—it’s the elective Iteach after they’ve had all their corpo-rate finance courses—“cash is king” isa very dangerous phrase. What com-panies should aim to maximize is notcurrent cash flow, but rather futurefree cash flow. If you don’t make that


distinction, you can run into majorproblems with performance measure-ment. For example, companies thatare continuously raising outside capi-tal to fund terrific growth opportuni-ties are likely to be adding significantamounts of value while showing in-creasingly negative free cash flow. Atthe same, companies with strong cashflow can be reducing value by passingup positive-NPV investments. Becausecurrent cash flow doesn’t allow youto distinguish between these twosituations, it is not a reliable perfor-mance measure.

What EVA attempts to do, throughits various accounting adjustments, isto bring accounting measures closerto cash flow by eliminating some ofthe more obvious distortions or biasescaused by accrual accounting. But letme give you one instance why thismight not always be a good idea. Andthat has to do with deferred taxes.One of the standard adjustments thatStern Stewart urges you to make—and McKinsey does the same thingwith its “Noplat” measure—is an ad-justment for deferred taxes. The ideais that deferred tax is basically anaccounting fiction. And what we wantis something more akin to cash taxes:the actual taxes that are paid by thecompany to the government in thatparticular year.

The problem with this—and thereis a growing body of literature that I’mattempting to add to with some col-leagues of mine at INSEAD—is that, infact, deferred taxes really and trulyhave relevance for how the marketvalues stocks. They really do tell usthings about future cash flows andfuture earnings. In a study I have justcompleted with colleagues Peter Joosand Jamie Pratt, deferred taxes areshown to be a powerful predictor ofboth the value relevance of earnings(that is, the statistical association be-tween earnings and stock price) andof earnings persistence (whether cur-

rent earnings are sustainable). In short,analysts can learn things about futureearnings—and future cash flows—from the magnitude of the deferredtax accounts.

So, when you come up with alter-native accounting measures—and, let’sface it, EVA is an accounting-based asopposed to a pure cash flow mea-sure—that go out of their way toeliminate something like deferredtaxes, you could be eliminating apotential source of information in theprocess. In other words, you could bereducing instead of increasing the

information content of the account-ing earnings number. And, in so do-ing, you run the risk of reducing thecorrelation between your measure ofperformance and shareholder value.

Now, I’m not quarreling at all withthe logic of the standard adjustmentsthat are suggested for EVA. In fact, Ifind the logic more or less impec-cable. What’s more, I admire SternStewart for the consistency of thelogic. But we do have to pass theempirical test. Despite the evidencethat they’ve produced, I don’t find itentirely convincing. And, as I’ve just

DavidYoung

Another important distinction

between EVA and the economic

profit measures that preceded it is

EVA’s emphasis on accounting

adjustments. Although I have some

disagreements with the way Stern

Stewart goes about this, I think

these adjustments are an

important part of the EVA story.

These adjustments are potentially

valuable because they allow the

EVA measure to be driven deep

into organizations. We want to

bring performance measures down

into the divisions, and all the way

down to the factory level if

possible, and then use it as part of

incentive compensation systems.


told you, I don’t think it’s always agood idea to make these adjustments.

In closing, let me just proposewhat I consider to be the four majorstandards that any company shouldconsider before they even think aboutmaking adjustments to their account-ing numbers for EVA purposes. Andthese are going to be different thanthe ones Bennett Stewart proposesin his book The Quest for Value. Idon’t disagree with Bennett on thispoint at all, and I want to be clearon this. I think what he proposesare all necessary conditions, butthey’re not sufficient.

First of all, we have to be convincedthat the generally accepted account-ing principle in question creates dys-functional behavior. We want to besure that the distortion or the bias inquestion is causing managers to en-gage in activities that might destroyvalue or to refrain from actions thatwould add value.

The second issue is that we have tobe convinced that whatever the ad-justment is—whether it’s somethingrelated to taxes, R&D, operating leases,or whatever—we can correct the dys-functional behavior, or at least reducethe likelihood of its taking place, bymaking the adjustment.

A third point that finance peoplealways ignore—but it is so important,as any accountant understands—isthat there are costs to deviating fromGAAP. In working with lots of CFOsand chief accountants in Europeancompanies, I’ve found that even thosewho are extremely enthusiastic aboutthe EVA concept are also very reluc-tant to deviate from GAAP-based num-bers. And, though there are a numberof reasons for this, I’ll just give youone. One problem with deviatingfrom GAAP that I hear a lot fromEuropean CFOs is that it underminesthe integrity of the accounting systemin the minds of company employees.Even if you believe that GAAP-based

numbers are garbage, the last signalyou want to be sending to your oper-ating managers is that the accountingnumbers are wrong. Because as soonas you start making the adjustments,the line managers will say, “Yes, Iknew it all along, even the accoun-tants are admitting it: you can’t trustthe accounting numbers, you’ve gotto make adjustments.” And I’m notsure that this is the sort of messagethat CFOs want to be sending.

So, again, the third major consider-ation in modifying GAAP is that theadjustment has got to overcome anycosts of deviating from GAAP. Inother words, the CFO and the chiefaccountant have got to be convincedthat whatever benefits you get interms of eliminating dysfunctionalbehavior will overcome those costs.And I’m not just talking about the out-of-pocket costs related to informationtechnology; I’m talking about some ofthe other more indirect costs as well.

The fourth and final issue, which isalso something that we often forgetabout, is that we have to be convincedthat there are not any other approachesthat might be able to accomplish thesame aim without deviating from theGAAP. For example, one of the ad-justments Stern Stewart urges peopleto make is to end the distinction be-tween investments in tangible assetsand investments in intangibles. Intan-gibles like R&D ought to be capital-ized and then amortized over an ap-propriate time period, just as youwould if you were to buy land, build-ings, machinery, or equipment. Onereason why you might want to do thisis to stop discouraging managers frominvesting in R&D. Capitalizing ratherthan expensing R&D also remindsmanagers that the company has toearn a return on that investment.

My concern, however, is that com-panies might be able to achieve thesame behavioral effect without chang-ing the accounting system. For ex-

ample, they might use balancedscorecards or other kinds of non-financial measures to encourage man-agers to invest in R&D. So I want to beconvinced that there are no othermechanisms that can achieve the samesort of desired result without makingthe adjustment to the numbers anddeviating from GAAP.STERN: David, I concede your pointthat the academic community has yetto produce empirical evidence thatEVA moves more closely with shareprices than other measures like earn-ings. But we may have to wait a longtime for an empirical test that qualifiesas truly scientific evidence. In themeantime, it seems clear—to us asleast—that our EVA system is capableof making profound improvements inmanagerial behavior. There are nowseveral hundred companies that canattest to this.

And let’s take as an example thisR&D adjustment that you just finisheddiscussing. Several years ago, we werehired by a company called Eli Lillywhich, together with Upjohn, was atthe bottom of the barrel in the phar-maceutical industry. To use a popularprice relative, Merck and their likewere trading about 25 times earnings,and Eli Lilly was at 10 along withUpjohn. That low P/E multiple tellsme, among other things, that thecompany has a low return on capitaland is likely producing negative EVA.

The CEO was new, he had justcome over from AT&T, where we hadworked with him on EVA, and he saidto us, “You’ll never believe what thesepeople do. Their bonuses are tied toimprovements in bottom-line profit-ability. So every time there’s pressureon profit margins, these guys try to cutback on the R&D to boost their near-term profits and retain their bonuses.I was thinking that what we might doto end that gaming is to simply do thesame calculation but before the ex-pensing of R&D.”


I said, “Yes, but that will create aneven bigger problem, because thenyou won’t have any financial controlson the R&D budget. With our ap-proach, the R&D goes onto the bal-ance sheet and this way they still haveto earn a return on the investmentover some acceptable period. And,with our bonus bank system, thosereturns have to be sustainable other-wise the managers will forfeit part oftheir bonuses if returns fall belowacceptable levels in the future.”

Well, the company put the programin place. And not only have earningsrecovered a good deal from a fewyears ago, but the stock is currentlyselling at 39 times those earnings.Lilly’s stock price is six times the valueit was three and a half years ago.

Let me also mention that, duringthat assignment, we had an encounterwith a group of scientists who wereengaged in what they called funda-mental research. They said to us, “Theproblem with your program, Joel, isthat you don’t care about our survivaluntil the year 2300.” And I said, “Well,your expected profits in that year dohave a very low present value, that istrue. Perhaps the company shouldtransfer some of that work to thePurdue University Medical Schoolinstead of taxing your shareholders.”

After going on EVA, Lilly’s R&Dprogram became decidedly more suc-cessful in developing new products.And, by the way, the company’s totalR&D spending went up, not down.So, it was not a complete surprise tome two years later when anotherpharmaceutical company, SmithklineBeecham, engaged Stern Stewart toimplement EVA.YOUNG: Well, let me just say a coupleof things. First of all, our ability togeneralize from these experiences islimited; we’re both operating from aselection bias, and it’s a pretty seriousone. I haven’t worked with hundredsof companies. I’ve worked closely

with fewer than 20. But I’m alsotalking about many executives com-ing through various seminars atINSEAD. So my obervations aboutEVA are based just on my own per-sonal experience. What’s more, mostcompanies that use EVA or similarvalue-based metrics do not adjust forR&D. Obviously, they feel that otheraspects of their measurement andcontrol systems encourage the rightsort of behavior.STERN: The other source of empiricalsupport for EVA—one which is farmore important to me, and to ourfriends in the academic community—has to do with the market’s reaction toannouncements of companies thatadopt our type of EVA program. Letme give you some indication of ourown confidence in the outcome. SternStewart, as a policy, attempts to takeas much as half of its fee in stockoptions that are illiquid for the firstthree years and that start out 25% outof the money. Now, when the com-pany announces that they’re going onto EVA, and that management’s incen-tives are going to be based on EVAimprovement, it has not been unusualfor the shares of those companies torise as much as 20% in one week.

So if we could document thatkind of market reaction for a broadsample of firms that go on thisprogram, and show that those gainsare sustained over time, would thatgive you enough comfort to allowsome slight adjustments to the or-thodox accounting model?YOUNG: What would provide realcomfort is if some independent finan-cial economist could somehow iso-late event time zero in the eventstudy, which is going to be a hardthing to do. And if we could get anindependent verification of this mar-ket reaction, that would make memore comfortable.STERN: Okay, we’re going to try toadd to your comfort over time. But let

me turn now to our next panelist,Antonio Vertucci. As I mentionedearlier, Antonio is the Controller andChief Information Officer of Ausimont,a leading chemical company fullyowned by Montedison.

EVA in Italy

ANTONIO VERTUCCI: Thank you,Mr. Stern, for inviting me to partici-pate on this panel. I have had aconsiderable amount of experiencewith EVA. In fact, in the last tenyears, I have had the good fortuneto see the emergence and diffusionof this new financial managementsystem from a number of very differ-ent perspectives.

At the beginning of this period, myinterest in the theory of the firm andin the emerging value-based manage-ment approaches helped me to dis-cover and appreciate the potential ofthe EVA system while I was still astudent at the University of MichiganGraduate Business School. That wasin the late ’80s, when the shareholderactivist movement was just in its earlyphase even in the U.S. Then, when Icame back to Italy and joined thebusiness community, I had the oppor-tunity to start testing as a practitionerwhat I had first studied in the U.S.

Among my first jobs after businessschool was a marketing assignment atNestlé, and this helped me to identifythe kind of support and performanceparameters that line managers reallyneed from the finance department. Italso showed me clearly how a poorcompensation system can lead todecisions that destroy value. All thisoccurred during the first part of the’90s, a period when EVA—while onthe rise in the U.S.—was virtuallyunknown in Europe.

In the last five years, my job ascontroller and CIO of Ausimont hasgiven me the opportunity to put myexperience with EVA to work. One of


my major accomplishments in this jobhas been the design and implementa-tion of a complete value-based finan-cial management system. And I wouldlike to use my remarks to exploreEVA’s potential for other Italian com-panies by sharing with you what Ihave learned so far in designing andimplementing EVA in a multi-busi-ness corporation.

But, before I get into this subject, letme comment on the proposition thatEVA is not new. In fact, the basic ideabehind EVA goes back well beforeAlfred Marshall and Adam Smith. Thinkback to the New Testament parable ofthe gold coins. If you remember thestory, a man of high rank was goingto a country far away to be made king,after which he planned to return.Before he left, he called his ten ser-vants and gave them each a gold cointo see what they could earn with thecoin while he was gone. When hecame back to his country, he orderedhis servants to appear before him andgive an accounting. While most of theservants had been able to turn thecoin into many more, there was oneservant who had simply kept his coinin a handkerchief. As punishment, themaster ordered that the coin be takenfrom that servant and given to the onewho had earned the most.

So, although there have been a fewrefinements since Biblical times inestimating the cost of capital, the ideathat capital has a cost in the form of anexpected return is not new. What isnew about EVA is the way SternStewart & Co. has used this basic ideato develop a very sophisticated andintegrated financial management sys-tem—a system that has put the find-ings of modern financial theory at theservice of corporate managers to helpthem improve corporate governanceand create value.

Now, to get into my subject, myexperience suggests that the adop-tion of an EVA system can help a

company create wealth even when itis run by an entrepreneur who isalready quite sensitive to the need tomake the most of scarce capital. Thissituation, by the way, which is quitecommon in continental Europe, iseven more the rule in Italy, where theentire economy is dominated by smallto medium-sized, privately ownedfirms. At the end of May 1998, of the4.7 million firms operating in Italy,only 7,400—or less than .2% of them—had more than 100 employees. In fact,57% of all Italian workers are em-ployed in firms with less than 20employees, a percentage that is twicethe level that prevails in France, Ger-many, and the U.K.

Many privately owned Italian firmsare highly entrepreneurial, innova-tive, and export-oriented, and havehigh levels of operating profitability.But, for reasons I will offer in amoment, such firms also operate witha very high level of bank debt. As agroup, they have created a very largeamount of wealth and helped Italy tobecome the world’s fourth largestindustrial country.

But when we look at publicly tradedItalian companies, the story is quitedifferent. According to some recentstudies by two leading investmentbanks, when corporate performanceis evaluated using Stern Stewart’s MVAmeasure, publicly traded Italian com-panies as a group destroyed share-holder value in every year from 1987to 1996. With this kind of scenario,one might argue that the potential forItaly to adopt EVA is restricted just tothe very small number of listed com-panies—those that as a group haveclearly failed to create value. And, infact, in the last two years the numberof these public companies movingtowards an EVA-like system has in-creased sharply, along with their lev-els of MVA. But even so, I continue tobelieve that large, private Italian com-panies are likely to benefit from an

EVA system. As these companies growand the European monetary integra-tion proceeds, they will need to findnew ways to sustain their originalcompetitive advantages—and EVA canhelp them do this.

The strength of many privatelyowned companies is the entrepre-neurial spirit of their founders, andtheir sense of the need to use capitalas efficiently as possible. This senseis particularly well-developed amongItalian private companies because ofthe severe limitations of Italian fi-nancial markets. Our capital market,in particular, has always been lessdeveloped than that of other indus-trialized countries—and it is still toosmall when compared to the needsof our firms. At the end of 1996, thetotal value of financial assets wasonly 4.9 times the level of our GDP,significantly lower than the level ofthe other major industrialized coun-tries. This same value was 5.6 forGermany, 7.4 for the U.S., 8.1 forFrance and Japan, and more than 10for the U.K. With our small, ineffi-cient capital market combined withour huge public budget deficits, ac-cess to capital for Italian private firmshas always been difficult and par-ticularly expensive.

The only easy way to finance growthhas thus been short-term bank loans.And this has forced Italian entrepre-neurs to become very efficient inusing and conserving capital. But thishistorical advantage is not likely tohelp much in the future. With thesingle European currency, the oppor-tunity to access to capital in othercountries will increase significantlyfor most companies, including Italianprivate companies. In this new sce-nario, capital will no longer be such ascarce and expensive resource.

So, how could such companiesbenefit from an EVA system? My argu-ment, in brief, is that to face the newkind of competition, these companies


must grow through acquisitions andinnovations. Perhaps equally impor-tant, they must solve the successionproblem that arises when theirfounders retire. Consequently, theyneed to move towards a managerialstructure that sustains profitablegrowth while at the same time keep-ing alive the entrepreneurial spirit ofthe founder. It is in this critical phasethat the adoption of an EVA systemseems to me crucial for the success ofthe new organization. As an effectivesystem of corporate governance, theEVA system can help spread a senseof meritocracy and ownershipthroughout the new organization.

Private companies dominated by asingle entrepreneur with very strongtechnical competencies also tend tohave less integrated and sophisticatedfinancial management systems. Forthis reason also, the adoption of EVAcould be highly beneficial by trans-forming a confusing variety of finan-cial measures and methods into acoherent, unified financial manage-ment system. The company I havebeen working in the last five yearsillustrates just this kind of situation.

When I joined Ausimont in mid-1993, there was a great sense ofuncertainty about the future of thecompany. Montedison, its parent com-pany, which was controlled at thattime by the Ferruzzi family, was closeto bankruptcy. The probability thatAusimont would be sold to a foreigncompetitor seemed very high.Ausimont itself was performing rea-sonably well; in fact, since taking overin 1990, the company’s entrepreneur-ial CEO had emphasized the impor-tance of using capital as wisely aspossible. But, given Montedison’s fi-nancial difficulties, all longer-termprojects were put on hold, and themaximization of current cash flowsbecame the overriding objective.

The situation faced by the parentcompany greatly influenced both the

organizational structure and the fi-nancial systems used at that time byAusimont. Ausimont’s Planning De-partment, under the strict supervisionand approval of the parent company’sIndustrial Control Bureau, had theresponsibility of analyzing new capi-tal appropriation requests. All thedifferent tools described in capitalbudgeting textbooks were used, frominternal rate of return to ROI, paybackperiod, and NPV. Since the short-termimperative was avoiding bankruptcy,only investments with very shortpaybacks and low capital require-

ments were accepted. Major strategicinvestments, designed to create fu-ture wealth and market position, werevirtually frozen.

To monitor the routine activities,there was a separate office, the Con-trol Department, which focused onjust one operating measure: the levelof earnings before depreciation, in-terest, and taxes (EBDIAT). The rea-son attention was put exclusively onthis parameter was that, given thepressure to generate cash, the onlyrequest of the holding company wasto maximize the absolute value of

AntonioVertucci

One major benefit comes from

the fact that EVA is not a ratio but

an absolute value; it measures

value added in dollars—or, in our

case, in lira. The problem with

focusing on ratios like ROI and

ROE is that they can discourage

managers from pursuing profitable

growth opportunities. To

understand how much value is

really created by an operation, you

need to know not only the return

on capital, but also the amount of

capital invested. EVA captures both

growth and profitability in a single

measure.


EBDIAT! At the same time, the Ac-counting Department continued tofocus on completely different mea-sures. Due to legal and fiscal con-straints, the relevant metrics moni-tored were statutory results and NetIncome. Finally, people in Marketingconcentrated exclusively on the bud-geted level of gross sales, since thiswas the only parameter that couldinfluence their compensation—andalso because this was the only de-tailed information readily availablefrom the MIS Department. The Con-trol Department, in fact, had neitherthe means nor the inclination to givefinancial management support tobusiness people.

This, then, was the situation inwhich we set out five years ago todesign and implement a value-basedsystem. Now, let me share with yousome of the results.

One of the first things we did wasto create one, uniform measure thatall the different departments coulduse as a common language and finan-cial objective. We created what isknown as a return-on-investment treefor each of our 15 businesses. The treeprovides a graphic representation thatbreaks down each operation’s ROIinto two components—return on sales(net operating income/sales) and capi-tal turnover (sales/total capital). Thesetwo components were then brokendown further into more elementarybusiness components, such as prices,margins, days of inventory, and so on.

One major benefit of this systemwas thus to help non-financial man-agers understand the relationshipbetween margins and capital em-ployed, as well as the sensitivity of themore elementary components to theROI of their activity. Moreover, toextend the new approach to sales-people, and to eliminate accountsthat were generating negative value,we provided them with statistics oncustomer and segment profitability.

Once this “tree” system was wellunderstood by our users, we com-pared the ROI of each relevant ac-tivity—whether a business, a plant,or a strategic business area—with itsown cost of capital. We did not fol-low the common practice of usingthe company-wide WACC as thehurdle rate for each of our busi-nesses. Instead we defined for eacha specific benchmark, a sort of ad-justed WACC intended to reflect theparticular strategy assigned to thesingle business. And it was whileusing this method that we becameinterested in EVA, and began toevaluate each of our different busi-nesses using that approach.

So, let me just briefly summarizethe kind of benefits we have seen sofar from EVA, and then I will close byraising some remaining issues thatmight need to be addressed.

One of the most important benefitsof EVA as a performance measure andmotivator is that the concept is veryeasy to understand—by people fromtop management down to the shop-floor operators. EVA, as I said, hashelped us to create a common lan-guage for use not only within andthroughout the corporation, but alsofor top management in its communi-cations with outside investors.

A second major benefit comes fromthe fact that EVA is not a ratio but anabsolute value, it measures valueadded in dollars—or, in our case, inlira. The problem with focusing onratios like ROI and ROE is that theycan discourage managers from pursu-ing profitable growth opportunities.A very high rate of return on a verysmall investment base may create farless value than a moderate rate ofreturn—though still above the cost ofcapital, of course—on a very largeinvestment base. To understand howmuch value is really created by anoperation, you need to know not onlythe return on capital, but also the

amount of capital invested. EVA cap-tures both growth and profitability ina single measure.

The third major benefit of EVA isthat it provides a measure that can beused for all corporate planning andfinancial functions. It is an all-pur-pose corporate governance tool. Be-sides performance measurement, EVAcan be used for capital budgeting andacquisition pricing as well as provid-ing a basis for management incentivecompensation. And this last feature inparticular enables the company toaffect the behavior of people through-out the organization.

When the company uses differentmetrics to guide the decision pro-cess, managers and employees areconfused and sooner or later adoptthe framework that makes it easiestfor them to achieve their own objec-tives. Before implementing the valuesystem I have just described, for in-stance, it was very common for ourbusiness managers to propose newinvestments that significantly in-creased the level of turnover, with-out paying attention to the level ofprofitability. And this was not at allsurprising, since their bonuses werelinked primarily to the level of sales.Now that they are evaluated accord-ing to the total value created by theirnew initiatives, they work closelywith the Planning and Control De-partment to ensure that their projectspass the EVA “test.”

To achieve all these benefits, how-ever, it has been necessary to makea few organizational changes and tosustain some costs. First, we havechanged the culture of the entireFinance Department. Since my ar-rival, I have worked hard to instillthe sense that the purpose of Fi-nance is to add value to the organi-zation by providing useful informa-tion to our business users. More-over, we have achieved some sav-ings as well as greater coordination


and control by merging three onceindependent offices—Planning, Con-trol, and MIS—into a single inte-grated Department.

As for the costs of implementingEVA, the major ones have derivedfrom the need to train people through-out the organization. The concept ofEVA has to be very well understoodby all the people that are going to useit. Otherwise, it can encourage short-term, opportunistic behavior. For in-stance, the reduction in working capi-tal achieved by factoring could im-prove one period’s EVA while result-ing in higher financial charges lateron. And an unjustified increase in thedepreciation life of an asset could alsoincrease near-term EVA without gen-erating real new value.

So, you have to train all the peoplein how to use EVA. And this may bethe biggest challenge in the entireimplementation process. My experi-ence tells me that you should ap-proach the implementation of EVA asa way to change the beliefs of thepeople in the corporation. For it isonly by getting managers and em-ployees to believe in the goals of theorganization that you can achieve thevalue-maximizing corporate culturethat Joel was describing. Managersand employees need to understand,first, why profits and efficiency are “agood thing”; they must be made to seehow greater profits and productivitylead to benefits for employees andlocal communities as well as for share-holders. And, second, employees mustbe shown how EVA can help themmake decisions that lead to greaterprofit and efficiency.

Now, having said this, I am notconvinced that EVA is right for allkinds of businesses. It is likely to bevery effective for large, mature corpo-rations that operate with lots of capi-tal. But it may not be appropriate forstart-up businesses where growth inrevenue is often the key objective. For

example, EVA would probably notwork well in a company likeAmazon.com. In such a case, EVA willbe negative while the company iscreating huge amounts of value for itsshareholders. Now, you could useStern Stewart’s strategic accountingmethod—the one that Joel describedearlier in which you keep largeamounts of invested capital off thebalance sheet for an agreed-uponlength of time. But it seems to me thestock market is effectively doing thesame thing—so why not just stickwith stock ownership or stock op-tions in such cases?

My final question about EVA hastwo parts. First, the growing impor-tance of knowledge—and intangibleassets of all kinds—in the economymay cause us to change the way weboth value and manage companies.There are companies where there arefew if any tangible assets. In suchcases most of the assets are in the formof intangibles like employee trainingand development, customer service,brand awareness, information sys-tems—all assets that require expendi-tures today to provide tomorrow’sgrowth opportunities.

The second part of this questionhas to do with the fundamental as-sumption of EVA and capitalism ingeneral—that value maximization isthe ultimate goal of the firm. The twoparts of the question are related inthe following sense. As people be-come more skilled and their knowl-edge becomes more critical in pro-ducing growth opportunities, it maybe more difficult to measure valueadded with a single-period measurelike EVA. It may also become moredifficult to motivate talented peoplesolely with monetary incentives. AndI offer this observation not as a criti-cism of EVA or pay-for-performancesystems, but only to point to oneimportant aspect of the future we arealready building.

STERN: Let me just respond quicklyto your last point. We’re not suggest-ing for a moment that money is every-thing. The case for EVA in Europe—and indeed everywhere—is based onthe premise that, in competitive labormarkets, where people get not onlysalary, but holidays, health benefits,and all kinds of things—the one thingthey don’t have is a potentially signifi-cant variable pay component. By in-troducing variable pay, and by tyingit to a measure that is highly consistentwith shareholder wealth maximiza-tion, we feel we can achieve somemajor improvements in productivity;we can change people’s behavior atthe margin.

In fact, of all the cases where we’veimplemented EVA, I can’t think of asingle instance where there was not anotable improvement in efficiency—and it’s simply because people are nolonger treating capital as a free good.After going on EVA, many of ourclient companies find themselves withso much capital that they do a Dutchauction share repurchase to disgorgethe excess. And by announcing theirintent not to tender their own sharesinto the offer, the top managers effec-tively signal to the market their ownconviction that the company is sub-stantially undervalued based on theirexpectations of future performance.

But let me return to your originalpoint that perhaps Europeans—orhighly talented knowlege workers—are less motivated by money. Youmay be right. But, as I said before,when added to the list of other ben-efits that people associate with a job,I continue to believe that monetaryincentives can play a significant roleat the margin. And, as economistsunderstand, there can be a lot of valueadded (or lost) by changes in behav-ior at the margin.VERTUCCI: Joel, I agree with youthat, in traditional competitive labormarkets at least, monetary variable


compensation can play an importantrole. My point, however, is that thingsare changing rapidly and a pay-for-performance system is only a neces-sary condition to retain knowledgeworkers; it is not sufficient to motivatethem in a way that encourages themto make full use of their creativepowers. Money, of course, does notnecessarily stop people from beingcreative, though in many situations itdoes not help—especially when theincentive system leads talented peopleto feel that they are being bribed orinduced to forgo other activities.

With the emergence of today’s so-called “experience economy,” wherecompanies no longer sell just goodsand services, but in many cases“memorable events,” creative andpassionate knowledge workers maybecome the truly scarce resource. Myexperience in coaching such employ-ees suggests that monetary compen-sation is necessary only to let themfeel that their talent is recognized andrewarded. What really motivates suchpeople is the way we design ourorganizations. As managers, we needto keep in mind that talented peopleare looking for three things in a job:(1) continuous challenge; (2) the au-tonomy to pursue the means theybelieve are necessary to reach thegoal; and (3) sufficient resources, bothin terms of time and money, to com-plete their task. Creativity flourisheswhen supervisors constantly encour-age it and, above all, when the entireorganization supports it in a way thatall people feel as if their contributionmatters to the company. When morecompanies learn to reward creativitywe will make real progress in creatingmore wealth—and a better world.

A Portuguese Perspective

STERN: Thank you very much, Anto-nio. Let’s turn now to the next mem-ber of our panel, Miguel Azevedo.

Miguel, as I mentioned earlier, is aninvestment banker with Central Bancode Investimento in Portugal.AZEVEDO: We have just heard arepresentative of a company tell ushow EVA can improve performanceby simulating ownership for employ-ees at various levels of the firm. I amgoing to discuss another potential useof EVA—that is, as a valuation tool forthe investment community. EVA pro-vides a way for outside investors toimprove the quality of their analysis.

EVA has considerable potential toincrease the degree of interactionbetween analysts and the companiesthey follow. So, for example, if acompany makes a public announce-ment that it is adopting EVA as amanagement tool, this provides asignal to the outside world that boththe performance and the transpar-ency of the company are going toimprove. I understand that, in somecases, Stern Stewart has implementedEVA in companies that prior to thispoint had never actually allocatedcapital to different parts of the com-pany. That is to say, before SternStewart’s arrival, the different busi-ness units had P & L statements, butno balance sheets. Needless to say,importing the capital discipline of anEVA system into such a company—particularly if the company is largeand diversified—could be a very ex-citing prospect for investors; the po-tential gains are very great.

Some people say that EVA is likelyto work well only in market-basedeconomies like the U.S. and the U.K.They suggest that most of continentalEurope is not ready for this kind offocus on shareholder value. Germanyand France are changing slowly—and in Spain, Italy, and Portugal, thepace of change is even slower. Sopeople are inclined to say, “Let’s leaveEVA to the U.S. and the U.K. andcome back in five years and thenwe’ll talk again.”

STERN: It’s never easy to be first withsomething new, I agree. But we havehad some very successful implemen-tations in Germany, and we’ve alsobegun working with some large com-panies in France. And, as I said at thebeginning, we have been workingwith companies in South Africa forwell over a decade.AZEVEDO: Well, South Africa is typi-cally considered to be a market-basedeconomy; it has an Anglo-Saxon asopposed to a continental Europeanculture.STERN: Oh, Anglo-Saxon, I see. Well,let me try a different tack. Perhapsthe best evidence that EVA can betransported to Europe would be oursuccesses in the U.S. with publicutilities and even non-profit institu-tions. In both of these cases, maxi-mizing value was not only a matter ofindifference to employees, it was noteven a distant concern of top man-agement. And the fact that an organi-zation like the U.S. Postal Service hasbeen in the black three years in a rowmay be the best evidence I can giveyou that EVA can build a culturefocused on adding value.AZEVEDO: Well, the Postal Service isactually a very interesting example, inpart because you have included “qual-ity of service” as part of the measure-ment system.STERN: Yes, that’s right. You see,when public utilities or governmentorganizations that may have a mo-nopoly on what they do go on to EVA,we often recommend that achievingminimal scores on a customer satis-faction be one of the necessary con-ditions for the incentive payments tobe made. That is, if they have a truemonopoly position, we don’t wantproductivity gains at the expense ofthe service they’re rendering.AZEVEDO: Joel, you may have thoughtI was going to say that EVA is notapplicable to continental Europe. ButI’m actually going to say the opposite:


That is, in less developed and lesstransparent markets, EVA is even moreimportant than in developed markets.Why is that? Because obviously thecorporate governance issues are moreimportant and more difficult to dealwith, and EVA could be very impor-tant in increasing credibility, transpar-ency, and the quality of research intothose companies. So, if a companygoes on an EVA program in a lessdeveloped country, I would say that,holding everything else constant, theshare price increase experienced by acompany going on EVA should actu-ally be larger than in a more devel-oped market. The expected gainsfrom EVA are even greater.

EVA also has one other importantbenefit for research analysts follow-ing a company. If an analyst uses anEVA approach when evaluating com-panies—as many of the most promi-nent investment banks are now do-ing—EVA helps analysts to put theright questions to management. Andthat has an immediate impact on thequality of the research. By reducingthe amount of uncertainty experi-enced by analysts, EVA-based disclo-sure has the potential to increase theconfidence of both analysts and theinvestment community. And this re-duction in investor uncertainty in turncould mean a lower cost of capital andhigher values for companies that learnto communicate effectively with thisnew EVA language.STERN: Let me just make a very quickcomment to you about the researchanalysts. An increasing number ofanalysts at investment firms likeGoldman Sachs, Morgan Stanley, andCS First Boston have been using EVAas part of their security analysis. And,as you have suggested, Miguel, one ofthe most interesting benefits of thisprocess is that analysts ask more pen-etrating questions. And when analystsask better questions, the result tendsto be a more meaningful dialogue

with management. Some analysts havetold me that, when they present theirown EVA analysis to the company,management sometimes responds byhaving their own finance and operat-ing staff review and comment on theanalysis, in some cases even makingcorrections where the analysis is offthe mark. And I don’t have to tell youthat that was not the kind of informa-tion they were getting from manage-ment before using EVA.AZEVEDO: I agree, and that leads tomy last point about EVA. It’s fascinat-ing to me the way in which this

methodology is gaining acceptance.Stern Stewart has long been tellingcompanies that the “lead steer” inves-tors use something analogous to dis-counted cash flow or EVA in settingstock prices. This argument has beenused to help persuade corporations toadopt EVA as an internal performancemeasurement system. More recently,Stern Stewart’s success in getting com-panies to use EVA internally has inturn convinced many security ana-lysts to adopt EVA as a valuationtool—which serves, of course, to re-inforce Stern Stewart’s original argu-

MiguelAzevedo

Was the investment community

really as sophisticated as Stern

Stewart has always made it out to

be? Or is this an evolutionary

development in which the market

becomes progressively smarter

over time? Either way, when the

analysts and institutional investors

begin pushing EVA on the

corporations whose stocks they

follow or own, those corporate

managers who have already been

interested in the concept really

begin to take notice.


ment to corporate management aboutwhy they should be using EVA in thefirst place.

So, there appears to be a circular-ity—or a kind of self-fulfilling proph-ecy—at work in all of this. It begs thequestion: Which came first? Was theinvestment community really as so-phisticated as Stern Stewart has al-ways made it out to be? Or is this anevolutionary development in whichthe market becomes progressivelysmarter over time? Either way, whenthe analysts and institutional inves-tors begin pushing EVA on the corpo-rations whose stocks they follow orown, those corporate managers whohave already been interested in theconcept really begin to take notice.So, this interest of corporate manage-ment in EVA, together with a strongendorsement by the investment com-munity, makes the case for EVA verycompelling.STERN: Miguel, I want to thank youvery much for helping me in mymarketing. I must confess to youthat, in my younger days, I spentmuch of my time wandering fromcompany to company—almost at ran-dom. And, if they did happen to letme in the door to talk about EVA anddiscounted cash flow, the invariableresponse from corporate managementwas, “But the markets don’t work thisway; all the market cares about isearnings per share.”

But let’s now turn to our finalspeaker, Massimo Spisni, who is aProfessor of Finance at the Universityof Bologna.

More on Italy

SPISNI: I’m going to share with youmy experience as an Italian teacherof corporate finance. Let me start byrepeating Julian Franks’ statement thatthere is nothing new under the sun.EVA is at bottom just a repackagingof a concept that can be found in

most finance textbooks published inthe last 30 years. But, if EVA is suchan old idea, why has it caught theattention of not just the press, butalso the boards of directors of somany companies?

First of all, I think the EVA philoso-phy offers a new management ap-proach to the general problem ofcorporate governance: how to getmanagers to maximize the value ofthe firm. This is the critical problemfacing companies not only in Italy,but throughout continental Europe—and, indeed, throughout the industri-alized world. Like David Young, inteaching corporate executives I toohave found them very receptive toEVA as a way of measuring internalperformance. But what I would like tofocus on in my remarks is what I taketo be a pronounced difference inmanagerial culture between conti-nental Europe and what Miguel calledthe Anglo-Saxon world of market-based economies.

The first thing that might strike anobserver of companies in continentalEurope is the extent of family owner-ship. To a far greater extent than inthe U.S. or U.K., even publicly tradedcompanies in continental Europe con-tinue to be characterized by largeblock ownership by the founder orhis heirs. Moreover, many privatefamily-owned businesses are nowconsidering going public—to securecapital for expansion and, in somecases, to provide a means for theowners to cash out and diversify atleast part of their wealth. In fact, Iwould describe continental Europeas undergoing a transition from pri-vate family ownership to becomingfamily-controlled public companies.This is important to keep in mindbecause, for the many listed Euro-pean companies that are under fam-ily control, it is of course the control-ling families’ aims that will dictate thegoals of the organization. In many if

not most such cases, the main objec-tive is not the maximization of share-holder value. Instead, the corporatemission is more likely to be to bal-ance shareholder returns against othergoals such as guaranteeing employ-ment and maintaining sponsorshipof local charities.

But, even if this family-controlledcorporation remains somewhat di-vided in its aims, EVA could be usefulin continental Europe because the“market discipline” is weak, and share-holder activism is in a relatively unde-veloped stage. In some sense, EVAcan provide an internal substitute forthe external market pressures that arestill notably lacking in countries likeFrance, Germany, Spain, and Italy.And EVA, by the way, is not necessar-ily inconsistent with these other ob-jectives. As Joel said earlier, by re-warding managers for greater effi-ciency, EVA helps organizations cre-ate value that can be shared by allcorporate constituencies—not justshareholders.STERN: It’s interesting that you shouldmake that point about family controlbecause some of our most successfulimplementations of EVA have beenin private firms where the familycontrols the company but profes-sional managers have been hired torun at least the day-to-day opera-tions—and in some cases the wholeshow. In such cases, the family own-ers have been looking for a way toalign the managers’ interests withtheir own without giving up legal titleand share ownership to outsiders.And that’s what EVA does: It simu-lates ownership by rewarding man-agers for performance and then giv-ing them strong incentives to sustainthat performance by putting part ofthose rewards at risk. You see, it’s thebuild-up of that deferred bonus ac-count that makes people act likeowners. And the idea that you cansimulate ownership for people all the


way down to the shop floor allowsEVA to become a vehicle for em-ployee capitalism. Given continentalEurope’s tendency to put the interestsof employees above those of share-holders, I would think that this aspectof EVA would be very appealing.SPISNI: In addition to changes infamily ownership, let me just mentionanother fairly new development inItaly. Of the roughly 250 Italian com-panies listed on the Milan stock ex-change, at least 50 companies arenow thinking about adopting stockoption plans. According to a recentsurvey on top executive compensa-tion by Towers Perrin, on average atleast 20% of the total compensation ofa top manager in France is paid instock options. Italian and Dutch man-agers are next, with around 10% oftheir pay in options. But German andSpanish companies don’t seem tomake any use of stock options.

Stock options and other innovativecorporate reward systems are poten-tially important in Italy because theyrepresent another means of aligningthe interests of managers with share-holder value. But the family owners oflisted companies are very reluctant touse stock options because of whatmight be called “dilution paranoia.”And there may be good reason forthis: As Warren Buffett and SternStewart and many others have pointedout, conventional, at-the-money stockoptions effectively reward managersfor mediocre performance. Since mostoptions have a five to 10-year life, thenatural upward drift of the marketover time is likely to carry all stockprices up, even if management barelysucceeds in earning the cost of capitalover that period.

And that’s another reason why EVAmight appeal to Italian family-ownedbusinesses. It effectively raises theperformance standard in such a waythat management is likely to be re-warded only when the owners out-

perform the broad market. Or, if thecompanies would like to use stock-based compensation along with EVA,then they could use some variation ofStern Stewart’s leveraged stock op-tions—the kind where the exerciseprice goes up each year at a rate thatapproximates the company’s cost ofcapital. This would also help ensurethat managers win only when theshareholders do.

Finally, let me just mention that afew investment banks in Italy arestarting to use EVA as a stock-pick-ing tool. A number of pioneering

studies of EVA have been done byIMI, one of the leading Italian invest-ment banks, which has also pub-lished a book called EVA. This is onemore reason why EVA is catching onin Italy. As Miguel said earlier, com-panies are becoming interested inEVA, the investment community ispushing companies to use EVA, andwe in the academic community aretelling our students—whether under-graduates or practicing corporate ex-ecutives—that they really need tounderstand the rules of the game inthe EVA world.

MassimoSpisni

EVA could be useful in

continental Europe because the

“market discipline” is weak, and

shareholder activism is in a

relatively undeveloped stage. In

some sense, EVA can provide an

internal substitute for the external

market pressures that are still

notably lacking in countries like

France, Germany, Spain, and Italy.


Rewarding Managers for GoodPerformance, Not Good Luck

STERN: Thank you, Massimo. Nowlet me briefly throw the discussionopen for a question or two. Julian,you earlier raised an issue about set-ting a different benchmark for evalu-ating corporate performance. Wouldyou mind restating it?FRANKS: My point was this: Whenyou evaluate a manager’s perfor-mance with EVA, much of the resultwill still be driven by external factors,such as boom or bust conditions inthe industry. To isolate managers’real contributions to value added,shouldn’t we attempt to adjust theirresults according to the strength ofdemand? For example, you mightwant to raise the cost of capital toreflect the fact that the entire industryhas had a great year—or lower thecost of capital if the economy goesinto recession. This way a corporatemanager’s performance would be “in-dustry-adjusted” in the same way thata money manager with a concentra-tion in financial services would beevaluated against, say, the S & Pindex of bank stocks.STERN: Well, I certainly see the logicof your idea. I agree with you that oneof the great weaknesses of any incen-tive scheme tied directly to share-holder value is that sometimes wehave to reward people for perfor-mance that results more from goodluck than good performance. But letme also point out, Julian, that underour EVA bonus bank, the lion’s shareof a manager’s bonus is held at riskand based on the sustainability ofresults. This way, if the economy hasbeen unusually strong and returns tonormal, then managers will forfeitpart of their windfall gain.FRANKS: Yes, but that really doesn’tsolve my problem. Why do we haveto reward management for luck, andnot performance? I find that odd. We

know that demand can be very vola-tile. For example, in Britain a year ortwo ago, growth expectations weresubstantially higher than they are to-day. And this means that, under yourEVA system, a lot of managers aregoing to produce much lower EVA,and receive much lower bonuses,because of changes completely be-yond their control. So, why not adjustEVA so that it takes account of broadeconomic or industry trends?STERN: For all the attractiveness ofthe idea, I think the potential costs ofmaking such an adjustment are likelyto outweigh the benefits—and fortwo main reasons.

First is that, by insulating managersfrom the business cycle, you reducetheir incentive to take measures thathelp the firm prepare for a downturn.People sometimes tell me that EVAisn’t well suited for cyclical industriesprecisely because of this problem.But we have found that not to be true.A number of paper companies havegone on EVA. Paper is a highly cycli-cal business, and the cycles tend to beaccentuated by an investment patternin which all the companies investheavily in the good times. In effect,they are all reinvesting their excessprofits—and then, when demandslows, they are all forced to retrenchand the industry is dragged down byhuge overcapacity. Under EVA, papercompanies are less likely to makethese large investments in the firstplace—they are more likely to usetheir excess profits to buy back theirshares instead. And, having refrainedfrom these ill-advised investments innew capacity, they are better pre-pared to deal with the downturnwhen it comes.

So, my first argument for usingplain old EVA—without adjustmentsfor demand—is that it forces manag-ers to plan for those shifts in demand.My second argument for not adjustingEVA for market conditions is more of

a public relations problem with theshareholders, but I think it’s an impor-tant one. Way back in 1982, we had anassignment from an oil company inwhich we were asked to come upwith a model that adjusted EVA for thelevel of oil prices. My colleagueBennett Stewart and I came up withsomething that was very much alongthe lines you’re proposing. Our modelbasically assumed that EVA for an oilcompany in any given year is a func-tion of three distinct components.One component is that part of EVAthat is attributable to the condition ofthe global economy. The second isthe part of EVA that is due to industryconditions. And the third and remain-ing part of EVA—what’s left after yousubtract the first two parts—is thecompany-specific EVA; it representsthe EVA that oil company managerscan control.

Now, in theory, what we’d like todo is to filter out the first two andalways reward the last one. But, as Itold Bennett one time, “I had a night-mare in which I was at the annualmeeting with the Chairman of thecompany and we were facing theshareholders sitting out front. Andthe Chairman said to the stockhold-ers, ‘Listen, it is true that our actualEVA has been horrible. But accord-ing to Stern Stewart, it’s not our fault.When you adjust our EVA for thelousy performance of both our in-dustry and the entire economy, we’veactually done quite well. And so thewhole management team here hasbeen paid gigantic bonuses. And wewant to thank Stern Stewart for point-ing this out to us.’”

Now, the reason why we’re allsmiling about this is that we know thatthat solution is not a politically ac-ceptable one, even if it turned out thatevery one of the academics in thisroom would agree with the method.So, perhaps you’re right, Julian: Whatwe are doing with our EVA program


may indeed be only a second-bestalternative. But, if so, I don’t believethat we can get the best one through.FRANKS: Joel, with your gifts of per-suasion, I refuse to believe that youcannot convince people to accept thebest solution. I have never known youto fail in the marketing of a goodidea—and some bad ones as well.

STERN: That kind of comment is justthe reason why I always look for-ward to seeing Julian at the LondonBusiness School—and why I’m nevertempted to want to see him any-where else.

And to all the rest of you who havevolunteered to serve on this panel, Ithank you very much for giving us

your time. My father always used totell me that I should never steal any-thing from anybody, not just becauseit was wrong, but also because it wasvery difficult to give it back andsquare things. In this particular in-stance, since I cannot give you backthe morning, I hope you’ve all had apositive EVA experience.

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stern stewart roundtable on eva in europe

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